The World Bank FPD Note No. 38 March 1995 Private Sector Development Department Vice Presidency for Finance and Private Sector Development Bankruptcy’s Role in Enterprise Restructuring: A Hammer to Turn a Screw? S. Ramachandran State-owned enterprise restructuring in the trans- forming economies of Eastern Europe and the former Soviet Union has been slower than many had hoped. Some have blamed the slow pace on the absence or inadequacy of bankruptcy laws and pro- cedures—and have advocated introducing bankrupt- cy law modeled on the best laws in Europe and the United States. And when that fails to accelerate en- terprise restructuring, they call for more judges and training or for mandatory out-of-court settlements. These prescriptions are contradictory and may be based on faulty diagnosis. Bankruptcy laws and procedures are not needed for the immediate problems in transforming economies: separating good firms from bad (for which cash or “hard budget” constraints suffice), liquidating value- subtracting firms, and financing potential value- adding investments. Indeed, the problem for which bankruptcy law is most needed—preserving going concern values when there are multiple claimants— may be several years away for most transforming economies. Furthermore, resource allocation is not materially affected by the choice of bankruptcy laws and procedures as long as the free-rider problem associated with multiple claimants in the same class is handled effectively (for example, through cram- down rules). While courts must approve agreements in bankruptcy cases if the agreements are to be bind- ing, such “rubber stamping,” done correctly, should not delay enterprise restructuring. A large backlog of bankruptcy cases is less likely to mean that bankrupt- cy courts or procedures are ineffective than that dis- puting parties have filed petitions to preserve their claims (or their position in the claimant queue) or as a negotiating tactic—or that claimants (usually the state as creditor or tax collector) lack the incentive to conclude them. In this last case, privatization of the claims may speed the process more effectively than training or short-cutting legal procedures. Bankruptcy law The term bankruptcy includes financial reorganization and liquidation.1 Financial reorganization simply re- arranges the claims on the cash flow (usually convert- ing part of the debt into equity and thereby reducing interest payments) without altering the firm’s opera- tions. Financial reorganization recognizes that the firm’s operations are sound even though its financial structure is not. Liquidation, however, ends the firm’s operation, dissolves the nexus of implicit contracts, and honors the explicit ones to the extent possible. The tangible assets are sold to pay the claimants, and, although the assets are redeployed, the going concern value is lost. Neither liquidation nor financial reorganization nec- essarily requires bankruptcy laws. When debts or other obligations cannot be honored, there is a breach of contract, and claimants can take their dis- putes to court. But generally they prefer instead to negotiate. When creditors perceive the problem as one of cash flow, not solvency (that is, when tangi- ble plus intangible assets exceed claims), they often agree to reschedule debts and stretch out payments —usually without involving courts. It is in the credi- Privatesector P U B L I C P O L I C Y F O R T H E 2 (for compliance with other laws and perhaps basic fairness) before it is “crammed down” the throats of free-riders. (So a “mandatory out-of-court settlement” is an oxymoron.) Bankruptcy laws are thus necessary only if a firm has (1) going concern value (when the firm must not be liquidated) and (2) multiple claimants within the relevant class (those who would be partially paid under liquidation), creating a free-rider problem. Therefore, early in an economy’s transformation (be- fore enterprises and claimants are partially or fully privatized), bankruptcy laws are not important. Some argue that such laws help resolve conflicting claims of different arms of the same government (ministries as owners versus state-owned banks as creditors versus the claims of tax collectors), citing the exam- ple of Poland.4 But Poland’s experience shows the importance not of bankruptcy law but of setting credible deadlines for bureaucrats. Bankruptcy law affects tactics—not outcomes If savvy negotiators see where their interests lie, the choice among bankruptcy laws matters less than the mushrooming literature comparing their features suggests. In each system, the courts usually get in- volved only when petitioned, but once involved, the judge plays a role that varies from one country to another. Even when courts are not actually peti- tioned before an agreement, their presence is impor- tant, and the perceived predictability (not fairness) of rulings determines the pattern and pace of negoti- ations. Depending on the likely ruling, each side would petition a court if, when, and where it be- lieves that it has a negotiating advantage. Thus, the differences among bankruptcy laws matter mainly for negotiating tactics, not outcomes (see box for further discussion). Sometimes court filings are obligatory (in Hungary, for example, a 1992 law made managers criminally liable if defaulting firms did not file for bankruptcy). Thus, a large backlog of bankruptcy cases may not mean that the relevant law is faulty or that the courts are slow. So, manda- tory out-of-court settlement procedures (known by a variety of names, from “workout units” to “accelerat- ed bankruptcy”) may be dangerously illegal and ultimately no faster because losers will appeal to courts under other laws. tors’ collective interest to avoid publicity. A function- ing firm is usually worth more than its tangible assets—and the difference is the going concern val- ue.2 But this value could erode if customers flee from a troubled firm, suppliers refuse to give normal trade credit, and workers migrate. So, claimants are unlikely to want to publicize the firm’s problems, even through court filings, while negotiations to reschedule unpaid debts are under way. Creditors often also have an incentive to negotiate because they are ill equipped to oversee the opera- tions of a firm (indeed, debt’s advantage over equity lies in not having to monitor agents as closely)— though they would need to oversee operations if they became the residual risk bearers of the firm (and hence the owners in an economic sense). For this reason, creditors often agree to let the old equity holders retain a stake (rather than wipe them out altogether) in the financially reconstituted company at the expense of their own—and the negotiations are often over how large a stake this will be. Even when parties are serious, however, agreement may take time because the negotiations take place in a fog of ignorance about going concern values. Claim- ants may perceive going concern value differently. These differences can be bridged using options and other contingent claims. But there still must be agree- ment on how to divide the going concern value. Such creditor-debtor negotiations and the redrawing of contracts usually do not require special (bank- ruptcy) laws or even court involvement. The excep- tion occurs when there are multiple claimants, which can give rise to two types of problems. First, the pecking order of claimants may not be specified in the contracts, or by custom, company law, or tax laws. Bankruptcy law can order the claims.3 Second, and perhaps more important, a claimant could with- hold consent to an agreement that is in the collec- tive interest in an effort to garner a disproportionate benefit. Such holdouts are within claimants’ contrac- tual rights and, if permitted, would prevent a negoti- ated agreement. Eliminating such free-riding requires a law that supersedes contract law under specified circumstances—bankruptcy law. Because applying bankruptcy law means denying some legal claims, courts must scrutinize the terms of an agreement 3 “Don’t fix what ain’t broke!” Whether a bankruptcy system needs fixing depends on the answers to three important questions: Are actual or potential value-adding firms getting the funds they need for sound investments? Are con- firmed value-subtracting firms being liquidated? And are the costs of delays in financially reorganizing sound but overly indebted firms fairly low? If the answer to all these questions is yes, there is no ma- jor problem needing to be fixed. Even defaulting firms can get additional finance (be- yond rollovers) for sound projects if creditors see their interests clearly. A self-interested creditor would distinguish between sunk costs and marginal decisions and extend further credit if it would be sensibly spent because it would increase the likeli- hood of the creditor’s being repaid. Free-riding could prevent this when there are multiple claim- ants, but mechanistic rules (internal rules and bank- ing supervisors commonly prescribe “no lending to defaulters”) could also prevent this sensible behavior even when there is only a single creditor. Bankrupt- cy law generally allows new creditors to step to the head of the claimant queue, but most firms in trans- forming economies still borrow from a single bank. If new credits are not forthcoming, the reason could be that aggregate savings are insufficient to finance the budget deficits and new investments or simply that the investments are not deemed worthwhile. Bankruptcy laws are not needed to close value- subtracting firms—a decision by the owner suffices (although in the United States, many firms are liqui- dated under chapter 7 of the bankruptcy code). And the government could be guided by a cash deficit or the accumulation of arrears (both tax arrears and arrears to the creditor bank, which is generally also state-owned) to judge which state-owned firms must be closed. Delays in financial reorganization of sound firms may not be overly costly. Although firms’ going con- cern value normally erodes during bankruptcy, if all firms in the economy are in the same boat, custom- ers and suppliers have little to gain from switching firms. So, the going concern value may not erode, thus reducing the incentives to resolve cases quickly but, at the same time, lowering the economic costs of backlog. This situation would change as new, sound firms are set up and old ones reorganized. Although a firm may continue to operate “normally” during bankruptcy, the indirect costs could be signif- icant because managers are distracted from the seri- ous task of running the firm by the minutiae of court filings and recontracting debts. Over time, this dis- traction takes its toll on the firm and on the econo- my. The question is how best to hasten the financial reorganization. Blaming bankruptcy laws and courts is usually wrong. Slovakia is an exception. The 1993 Who has the best law of all? Critics unfairly characterize the U.S. bankruptcy law as too pro-debtor because it allows managers (appointed by equity holders and so thought to be beholden to them) to continue to run the firm while negotiations are under way (unlike in the United Kingdom, where someone else is immediately put in charge) and gives them exclusive right to propose a re- organization plan. Although owners (the board of directors or their managers) commonly file for “protection from their creditors” (under chapter 11 of the U.S. bankruptcy code), semantics aside, this is not evidence of a pro-debtor bias because preserving the going concern value also benefits other claimants. Chapter 11 allows new creditors to step to the head of the claimant queue, thereby permitting suppliers (also creditors until they are paid) to ship goods and allow- ing the firm to operate. This preserves the going concern value over which the old creditors have a claim. Whether it is better to entrust the operation of the firm to the existing managers—who may know the firm best—or to appoint a new overseer matters little if only the timing of the bankrupt- cy filing and the pattern of negotiations are affected. Other purported evidence that the U.S. system is more prone to liquidations is also misleading: while some 80 percent of U.S. firms filing for bankruptcy are liquidated, the characteristics of firms filing differ systematically across countries (reflecting diverse negotiating tactics) and such comparisons are mean- ingless. The U.S. system is faulted for other reasons, too, but all such flaws, whether real or perceived, are mitigated if the bankruptcy process is swift—and the U.S. system is swift except in complex cases in which the informed consent of numerous claimants must be obtained. If European bankrupt- cy is faster, it may be because the primary claimants are often a few sophisticated banks rather than atomistic bond- holders—not because of better bankruptcy laws or proce- dures. It is well to bear such features in mind when recom- mending laws to other countries. 4 This series is published to share ideas and invite discussion. It covers financial and private sector development as well as industry and energy. The views expressed are those of the authors and are not intended to represent an official statement of Bank policy or strategy. Printed on recycled paper. Comments are welcome. Please call the FPD Note line to leave a message: 202-458-1111; or contact Suzanne Smith, editor, Room G8105, The World Bank, 1818 H Street, NW, Washington, DC 20433, or Internet address ssmith7@worldbank.org. of claimants who may get paid, albeit partially if they are “partially under the water”) keep a finger on the bankruptcy trigger. These parties should know the firm’s business, be adept at negotiations, and not be plagued by the free-rider problem. Such an ideal combination is rare, but laws often reorder the pecking order of claims to ensure that it is possi- ble. Any change in the trigger finger must be tai- lored to the circumstances of a country. This Note can only convey the flavor of what could be done. Illustration by Ruth Sofair Ketler. 1 The terms are not standard even within a country, adding to the con- fusion. Liquidation is sometimes used (instead of dissolution) to de- scribe the demise of the legal entity rather than the operations. Thus, the sale of a firm’s operations, possibly to creditors, and the liquidation of the old corporate shell left behind (which does not destroy the going concern value) is sometimes called liquidation. The French term faillite is analogous to the umbrella term bankrupt- cy, but if fraud is involved, the term is bankqueroute (from banca rotta, the medieval practice of publicly breaking a defaulting money- lender’s bench in the Rialto, the Venetian credit market). The French liquidation describes the same process as the English equivalent, but if the process is court-supervised, it is liquidation judiciare. Court- supervised financial reorganization is redressement in France and concordat in Belgium. 2 Going concern value stems from the nexus of implicit contracts with suppliers, customers, workers, and the like. It is analogous to, but not synonymous with, goodwill (an accounting asset when a buyer pays more than book value for a firm) and the “Tobin q” (an economist’s construct for a firm’s equity selling for more than the market value of the underlying assets). While there is a presumption that value- subtracting firms with persistent cash deficits or operating losses lack going concern value, that is not always the case because some parts of the operations may have such value. 3 Countries differ greatly in how they package various legal provisions. Asset disposition is governed by bankruptcy laws in one country, and by the civil code in another. This Note does not address the merits of alternative clusterings. 4 Poland already had a bankruptcy law when the Law on the Financial Restructuring of Enterprises and Banks became effective in March 1993. This law forced state-owned creditor banks to either recontract the bad loans or force the debtor enterprises into liquidation by March 1994. The law imposed a credible penalty: banks that did neither had to sell the bad loans in the market (and the likely price became the creditors’ reservation price during negotiations). The law was meant mainly to prod bank bureaucrats, but might not have worked if bank privatization had not already begun. S. Ramachandran, Senior Economist, Private Sector Development Department amendments to the Slovak bankruptcy law gave all claimants equal say regardless of the amount they were owed, encouraging free-riding. Moreover, sug- gestions for relieving court congestion (“hire more judges”) are akin to widening one of many busy feeder roads: the road gets clogged again as motor- ists change route. Courts will always seem to be bottlenecks, and the solution lies elsewhere. Cutting the Gordian knot Negotiations lie at the heart of bankruptcy, and for these to get under way, the parties must have both expertise and the incentive to act. It is all too easy to exaggerate the lack of expertise (especially when the parties have never done a bankruptcy) and ad- vocate training programs. But offering assistance— besides giving the comforting illusion of action and being costly—could further delay resolution as par- ties stop negotiating and await the arrival of the mir- acle arbitrator or procedures. The real problem may lie with incentives. Negotia- tions require judgments, but bureaucrats prefer me- chanical rules, which are less likely to be subse- quently challenged. So, if either debtors or claimants (or both) are state-owned, nothing may happen until the firms and state-owned creditor banks are priva- tized. Even if privatized banks cannot drive the ne- gotiations because large tax arrears are ahead in the queue of claims, the hierarchy of claims could be amended (not necessarily through bankruptcy law) to restore the incentives of claimants who could hasten the process. For example, when there are multiple classes of claimants (tax collectors, unpaid workers, unpaid suppliers, secured creditors, bond- holders, bank creditors), those last in line may re- ceive nothing if the proceeds are insufficient (“under the water,” in the parlance). So, even if they knew the firm was insolvent, these claimants would do nothing to force the issue—nor would those who are sure to be paid. The trick in an effective bank- ruptcy system is to have those facing the greatest risk of being “out of the money” (such as that class